QUALIPORT
Great Companies Of Tomorrow

By Maynard Paton (TMFMayn)
October 27, 2003

Investors dream of finding small companies that go on to evolve into great long-term businesses. For instance, the likes of Vodafone (LSE: VOD)(NYSE: VOD), William Morrison (LSE: MRW), Sage (LSE: SGE) and Capita (LSE: CPI) have all produced fantastic rewards to those who spotted their early potential.

Two small firms that could become 'great companies of tomorrow' are Invox (LSE: INX) and themutual.net (LSE: TMN). Their mouth-watering accounts, which include high operating margins, little capital expenditure, low working capital requirements and sizeable cash balances, appear to highlight two solid businesses.

Invox

Invox has a market value of £51m and the following table summarises its short listed history:

Year to June 30                 2001         2002        2003

Turnover (£m)                    0.1         13.3        18.2
Operating profit (£m)           (1.2)         3.3         6.0
Pre-tax profit (£m)             (0.9)         3.4         6.1

Earnings per share (p)          (0.3)        22.1        27.0
Dividend per share (p)             -          7.0        20.0

The company develops competition scratch cards and generates its revenues through premium-rate telephone income. The cards are distributed as inserts by newspapers and magazines, and those readers with the winning cards can claim their prize by calling a third-party automated call centre.

Admittedly, it's not the most laudable of businesses and as Invox notes: "Success in other European Union countries will depend on the regulatory environment as it does in the UK, and the Board remains keen to broaden the Group's trading activities." The firm has also had the odd run-in with the telephone information services regulator, ICSTIS.

Still, the accounts are great. Operating margins were a wonderful 33% in the year ending June 2003. Furthermore, Invox reported tangible fixed assets of zero (yes, zero) on the balance sheet, and zero (yes, zero again) capital expenditure as well. In addition, the firm has produced an inflow of working capital cash for the last two years. The asset-light nature of the company aided a near tripling of the latest dividend and even following the payment, £4.5m net cash will remain on the books.

themutual.net

themutual has a market value of £7m and the table below shows its four-year stock market history:

Year to April 30           1999      2001      2002      2003

Turnover (£k)               273       476       821     1,373
Operating profit (£k)      (715)   (1,252)      (33)      547
Pre-tax profit (£k)        (717)   (1,221)      (28)      558

Earnings per share (p)   (0.037)   (0.035)    (0.00)    0.015
Dividend per share (p)       -          -         -         -

themutual describes itself as a 'consumer club' and rewards its members with free shares. Members sign up to shop at the company's 200-plus partner sites and opt-in to receive special offers by e-mail. themutual's income is therefore derived from businesses wishing to market their wares through the company's subscriber database.

Like scratch cards, 'spam' may not to be everyone's liking, but it sure makes a whole heap of money. Operating margins were 40% in 2003, which for such a small business is frankly astounding. Meanwhile, a £547,000 operating profit was produced from tangible fixed assets of only £14,000. An aggregate net inflow of working capital cash has been produced over the last two years and net cash in the bank stood at £720,000 earlier in the year.

Summary

Will Invox and themutual become buy and hold franchises? Certainly the shares fit many of the business and financial criteria the Qualiport demands. However, both fail two critical hurdles: a sustainable competitive advantage and a proven track record.

Sadly, the stock market is littered with businesses that produce great accounts for a few years, but then stumble and disappoint thereafter. Competition is by far the greatest danger for small businesses and it's not clear whether Invox or themutual have the wherewithal to beat off newcomers attracted to their lucrative activities.

Producing competition scratch cards doesn't seem to have an obvious moat, save for perhaps the possibility of onerous regulations acting as a barrier to entry. With online marketing, it's fair to say none of the 'snail mail' equivalents have ever developed into the stuff of stock market legend. Indeed, most Internet businesses have e-mail lists that could be of interest to third-party marketing departments.

A case for 'quality' could be made if Invox and themutual had long, illustrious records and so had been tested over time. Unfortunately, one or two years of profitability are all investors have to go on -- not enough for this buy and hold portfolio.

Of course, the same 'moat' and 'proven record' arguments would undoubtedly have been aired against Vodafone, Morrison, Sage and Capita when they were corporate minnows. But as the market's behaviour of years past shows, such obviously great, proven businesses do sometimes sell at bargain prices. When all that's required to buy 'quality' is patience, why take a risk with something else in the meantime?

More: The Ideal Qualiport Share